Stay calm.Stay invested in good stocks for the long haul as it reduces the impact of fluctuation on your returns

Seek good value. Avoid overvalued stocks. Pick reasonably-valued stocks where there is still scope for appreciation

Go for cash flows. Look for companies that have a strong balance sheet and stable cash flows to sustain periods of downturn

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In the last few quarters, retail investors have become increasingly shy of investing in equities. This is evident from the declining portion of free float (shares readily available for trade) held by retail investors in the Indian stockmarket. This, despite the fact that equities are known to fetch higher returns than most other asset classes. So, what is stopping the Indian retail investor from going in for stocks?

Most of us did not participate in the rally that started in March 2009. It was too quick to take a callthe benchmark index, Sensex, moved up over 100 per cent in just six months. And now, even though we have seen the resilience of the equity market, we face indecision. Investors are retreating from equity markets probably because of uncertainty on two fronts: where are we today and what should be the appropriate investment strategy in this new environment?

Here, we will answer both these questions and subsequently help you in devising a suitable strategy.

A new environment

Rich valuations. A good way to judge whether you are paying the correct price for a stock is to look at its earnings multiple, or the PE (price-to-earnings) ratio. Similarly, a market's index PE indicates how fairly that market is valued. The Sensex is trading around 22 times its earnings. On its own, this figure doesn't not say much. Compare this with the average PE at which the Sensex has historically been, and you will have cause for worry. Says Vetri Subramaniam, head, equity funds, Religare Mutual Fund: "At current levels (Sensex at 17,000), valuations are pushing outside the comfort zone relative to our past history." The Sensex is currently priced higher than its 10-year average PE of 18.

Dominant market forces.Market forces have always influenced stock behaviour. However, they gained even more prominence during the financial meltdown in 2008. Even stocks of companies with sound business models were hammered. Says a report by Morgan Stanley, a financial services firm: "The influence of the market on stock returns has been high over the past 18 months, with stock specific idiosyncratic factors taking a back seat."

Your strategy in 2010

Old wine, new bottle.So what should be your investment strategy in this new environment? Should you reduce your focus on company fundamentals as market forces have been dominant for some time now? Not really. Says Subramaniam: "With valuations having discounted the recovery and pushed outside the comfort zone, we believe the upsides from here are likely to be driven by stock picking rather than by macro factors."

If your return expectations from stocks are high, you must be ready to take high risk, and vice versa

This view is shared by other experts in the market as well. "Our conclusion is that stock picking may become more important in 2010, relative to where it has been over the past two years," acknowledges the same Morgan Stanley report that highlighted the importance of market forces.

At Outlook Money, too, we have always highlighted the importance of stock picking. We have earlier suggested that you look at company fundamentals and not overemphasise the importance of market forces. Here, we reiterate our stock picking strategy, which will help you sail through the potential volatility ahead.

Set goals. The first step towards stock picking is to set investment goals. If your return expectations from stocks are high, you must be ready to take a high degree of risk, and vice versa. For example, you could look out for mid- and small-cap companies if you want higher returns from stocks. These stocks are not widely tracked by market participants and, therefore, chances are less that they have fully appreciated in value. However, a risk with such stocks is that since they are not widely tracked by the market, you might not notice certain flaws in the company's business. And once the market discovers those flaws, the company's share price could get hammered.

Bottom up.Start analysing the fundamentals of companies that match your risk and return profile. The process involves studying the financial position of companies. Once you know the company is financially strong, you will need to look at the industry it is a part of. Industry dynamics exert a big influence on a company's business. In the long term, a company can't grow faster than the industry in which it operates.

So, to ascertain whether a company has the potential to grow fast, you would need to evaluate its industry's growth prospects.

Don't ignore the balance sheet. Most investors do not realise the risk of a highly-leveraged balance sheet. They focus only on the company's income statement. Companies do not publish balance sheets frequently. Every quarter, they simply release their income statement. However, the effect of leverage became visible during the current downturn. Companies that had weak balance sheets were badly affected.

Despite all this, markets seem to have learnt little. The focus is turning back on growth potential. Analyst reports, too, do not talk any more about a company's debt and its cash position. If you are also ignoring the importance of balance sheet, you could be accumulating risk in your stocks portfolio. "If the company is leveraged, it will show humongous profits; but one day the market would realise that balance sheet risks are just too much, and it will hammer the stock," warns Manish Sonthalia, portfolio manager at Motilal Oswal Securities, a financial services firm.

Tide over volatility.You may be worried even if you have found a fundamentally strong company in a growing industry because of the short-term volatility you expect. You may not be able to decide which way the stock price will move. Therefore, timing the market is certainly not the way out. "For the retail investor, the best bet is to stay invested and tide over the short-term volatility," says Prasun Gajri, CIO, Standard Life Insurance.

Sell decision. Knowing when to sell is probably the trickiest question in formulating a strategy. When you buy a stock, one of the basic assumptions is that it is trading below its real value. Analyst reports call this real value "target price". Based on certain assumptions, even you can set a target price for the stock.

After you do that, you expect the stock to reach its target price over time. Once the target price is reached and you think the stock may become overvalued, you should sell it.However, just reaching the target price does not necessarily warrant a sell. "Target price is a moving thing as business dynamics change," says Sonthalia. Therefore, if the dynamics of a business are continuously improving, you may continue to hold its stock even if the target price is reached.

Likewise, if you notice a fundamental problem that you ignored earlier, you must adjust your target price. You may even need to sell the stock.

Experts' picks for 2010

Rajat RajgarhiaHead, Research, Motilal Oswal Securities

Hero Honda

Market price:Rs 1,666Its balance sheet is among the best in the industry. The management's sharp focus on the growing two-wheeler segment enables it to capitalise on the opportunity that exists in the sector. Earnings will continue to grow at 15-20 per cent over the next few years.

Bharti Airtel

Market price:Rs 316The concern on pricing is unsustainable, and Bharti Airtel is still the best player in this environment. It can compete well with new and existing players given its strong base and low cost.

State Bank of India

Market price: Rs 2,180.75With its extensive network, it should be able to capitalise on loan growth. Also, given the kind of return on equity it generates, the stock is cheap at 1.3 times its book value.

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Amar AmbaniVice-President, Research, India Infoline

HDFC Bank

Market price:Rs 1,801A top play in the ensuing credit upcycle, its loan book should grow by 26 per cent in FY10 and 27 per cent in FY11.

Punj Lloyd

Market price:Rs 204It is the only mid-cap engineering and construction company with the necessary skill sets to leapfrog into the space created by L&T. Its outstanding order book stood at Rs 26,800 crore at the end of Q2FY10, providing earnings visibility for the next two years.

Aban Offshore

Market price:Rs 1,320One of the largest rig operators in the world, it is set to leverage on the rebound in global exploration and production (E&P) investments. The company enjoys strong revenue visibility for the near term.

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Dipen ShahSenior VP, PCG research, Kotak Securities

NIIT

Market price:Rs 73Its revenue growth is likely to be better in FY11 with all businesses expected to revive. Significant margin improvement is also expected. The stock is available at nine times FY11 earnings, which is attractive.

Indian Bank

Market price:Rs 174It has a strong liability franchise (CASA at 31 per cent at the end of Q2FY10) with low dependence on bulk deposits. Net NPA and gross NPA are among the lowest in the industry. A better return profile than peers justifies its premium valuation.